The period from 2009 to 2021 was the dream environment for the long-only U.S. equity and bond portfolio, the investment vehicle for many American pensions. There are three reasons for this:

  1. U.S. equities soared with the S&P 500 returning nearly 500% above T-Bills.
  2. Long-term U.S. Treasuries returned 60% more than T-Bills.
  3. U.S. stocks and bonds had a consistently negative correlation, which meant that the combination of being long stocks and bonds delivered an exceptionally high risk-adjusted performance (Figure 1). 

Figure 1: Macro hedge fund strategies hit a snag during ZIRP and have revived since

Corporate bonds also performed well, with the Bloomberg High Yield Index rising 260% as option-adjusted spreads over U.S. Treasuries narrowed from 16% in early 2009 to below 3% by late 2021. Pension managers also did well with allocations in less liquid strategies, whose returns mirror those of public markets such as private equity, private credit, venture capital and infrastructure investments.

Meanwhile, hedge fund strategies such as trend-following CTAs and global macro, which had exceptional returns from the 1990s until the global financial crisis, struggled during the 2009-20 period. Hegde fund strategies typically invest their capital in accounts that earn the risk-free rate and use those accounts to collateralize long and short positions in derivative markets. As such, when short-term interest rates hit zero in 2009, it deprived hedge funds of a cushion to absorb trading losses and a springboard to enhance trading gains.

Additionally, this was a period of generally low volatility and weak trends in most markets, which made it difficult for CTA managers to generate returns above their cost of trading. Global macro managers also had difficulty generating returns during the 2010s as most advanced economies were delivering similar growth amid low, stable inflation and near-zero rates.

Since 2021, however, there has been a radical change in the investment environment for five reasons:

  1. The negative correlation between stocks and bonds has flipped back to positive. Mathematically, a positive correlation means less diversification for those who are long both equities and bonds (Figures 2 and 3).
  2. U.S. Treasuries have plunged in value as both short-term interest rates and long-term bond yields have soared (Figure 4).
  3. Spreads on high yield bonds over Treasuries remain historically narrow, implying that high yield bonds are likely to struggle to get exceptional returns unless spreads narrow further to unprecedented levels (Figure 5).
  4. Equities have also been delivering lower returns with a severe bear market in 2022 followed by a recovery in 2023 and thus far in 2024 that has allowed some benchmarks like the S&P 500 to slightly outperform T-Bills while others like the Russell 2000 index lag behind (Figure 6).
  5. Higher financing costs threaten many long-only investments from private credit, private equity and venture capital. Commercial property prices, in particular, have plunged in value. 

Figure 2: Higher inflation has pushed the equity-bond correlation back positive

Figure 3: Long-only equity/bonds portfolios did exceptionally well under negative correlation

Figure 4: Higher inflation has pushed long-term bond prices down by 50% since March 2020

Figure 5: Corporate bond spreads over Treasuries are near historic lows

Figure 6: Since November 2021, large caps have barely outperformed T-Bills

Any long-only investment must return more than T-Bills to justify the risk. It was easy to argue for taking leveraged long-only risks when T-Bills rates were close to zero. It is more difficult to make the case for such investments when T-Bills return 5% per year. By contrast, 5% T-Bill yields are tailwind for CTA trend followers, currency overlay and global macro managers.

Inflation underpins the change in the correlation between stocks and bonds. From the 1970s until 1998, equities and U.S. Treasuries typically had positive correlations, often around +0.4. The reason for this was that investors’ fears primarily focused on inflation. When economic data came in stronger than consensus, bond yields typically rose, pushing bond prices lower. Equities usually moved in the same direction as bond prices as higher yield would attract capital away from stocks.

Positive correlations between equities and bonds began to erode in 1998 with the Russian default and the Long-Term Capital Management (LTCM) hedge fund crisis. When investors fear financial instability more than inflation, the equity-bond correlation tends to flip to negative, which enhances the diversification inherent in the long-only equity and bond portfolio. This change in correlation gained further momentum during the 2001 tech wreck recession in which equities prices and bond yields fell while bond prices soared. The 2008 financial crisis finally pushed the equity-bond correlation into deep negative territory where it remained for more than a decade. A period of low inflation was key in facilitating this change in market psychology and correlation structure.

In 2021, however, the resurgence of inflation pushed the equity-bond correlation back into positive territory and the risk-adjusted performance of a mixed equity/bond portfolio deteriorated sharply as seen in Figure 2. While equities rebounded in 2023 and thus far in 2024, bonds have not recovered.

Meanwhile, highly varied economic performance around the world, with the U.S. economy still growing quickly, China underperforming, and Europe and Japan caught in the middle, could unleash strong macro trends that could allow both global macro and CTA trend followers to generate positive returns streams with low correlations to both equities and bonds. Indeed, these sorts of strategies have seen a strong rebound in their performance thus far in the 2020s (Figure 7).

Figure 7: Higher rates and macroeconomic divergences have boosted hedge fund returns

The outlook for the relative attractiveness of long-only versus hedge fund investing could be determined in large part by what happens to inflation. Inflation rates were low and stable from 1992 to 2021. There are a number of reasons for this:

  1. The end of the Cold War meant much lower levels of military spending, making more resources available to invest in productive capacity that creates goods and services.
  2. The expansion of free trade through the General Agreement on Tariffs and Trade (GATT) and its successor, the World Trade Organization (WTO), which reduced trade barriers and trade friction.
  3. The integration of China and the former Eastern bloc into the global economy initially came with extremely large labor cost differentials that helped to suppress wage growth in the goods producing sectors of high-income countries and flood western economies with inexpensive manufactured goods.
  4. Productivity growth surged from the mid-1990s until the global financial crisis as a result of the first wave of the internet cutting out middlemen.

Now, many of these trends have either halted for reversed.

  1. With geopolitical conflict rising, defense spending is increasing as a share of global GDP.
  2. The trend towards expanding free trade has reversed into a global wave of protectionism, onshoring and nearshoring of production which is inherently inflationary.
  3. Once low-income countries, like China, are now middle-income countries and are no longer supplying goods as inexpensively as they once did.
  4. Productivity growth slowed dramatically as the second wave of the internet, focused on social media, did little to advance productivity. That said, generative AI has the potential to create a third period of rapid increases in productivity growth that could suppress inflation, particularly in the service sector. That, however, remains to be seen and gen AI could also drive inflation by putting additional pressure on electric grids, chips manufacturers and copper producers.

These factors could prove to be inflationary and could keep short-term rates higher for longer. Additionally, even if rate cuts do materialize, as is widely anticipated in the interest rate futures markets, policy rates could remain well above zero.

It's worth noting that the low inflation period of 1992-2021 was not the first such period in history. The U.S. also enjoyed low-inflation from 1954 to 1965 when long-only bond and equity portfolios prospered. This period was followed by an initial surge in inflation from 1966 to 1969 as the U.S. economy overheated in the late 1960s amid the Vietnam War and Great Society. Inflation rates came down between 1969 and 1972, but not all the way down to its previous levels, only to have two massive waves of inflation from 1973 to 1980 (Figure 8). 

Figure 8: Does the recent surge in inflation resemble that of the 1965-69 period?

One might wonder if the global economy is on a similar course this time. While inflation has receded from its peak of 6.6% ex-food and energy in 2022, its still running at roughly twice its pre-pandemic norm. If inflation does not return to pre-pandemic levels, it could have negative implications for long-only investors in bonds and equities. During the 1970s, bond yields soared and equity prices range-traded, losing as much as 70% of their value in inflation-adjusted terms. The S&P 500 market cap fell from 110% to 25% of GDP (Figure 9). 

Figure 9: Equity valuations in the U.S. may be stretched at current levels.

Currently, equities are trading near record levels in terms of the ratio of market cap to GDP, and other measures such as price-to-sales and price-to-book ratios are also at historic highs. Given the possibility that valuations are stretched, equities could underperform even if inflation and bond yields don’t rise further. As such, some investors might consider alternatives that offer low correlation to traditional equity and bond investments and could perform well in a higher rate environment. 

Investment strategies

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